Question

5. Correcting for negative externalities - Regulation versus tradable permits Suppose the government wants to reduce the total pollution emitted by three local firms. Currently, each firm is creating 4 units of pollution in the area, for a total of 12 pollution units. If the government wants to reduce total pollution in the area to 6 units, it can choose between the following two methods: Available Methods to Reduce Pollution 1. The government sets pollution standards using regulation 2. The government allocates tradable pollution permits. Each firm faces different costs, so reducing pollution is more difficult for some firms than others. The following table shows the cost each firm faces to eliminate each unit of pollution. For each firm, assume that the cost of reducing pollution to zero (that is, eliminating all 4 units of pollution) is prohibitively expensive. First Unit of Pollution (Dollars) Firm Firm X Firm Y Cost of Eliminating the... Second Unit of Pollution (Dollars) 70 800 Third Unit of Pollution (Dollars) 110 55 650 1,500 Firm Z 90 125 180 Now, imagine that two government employees proposed alternative plans for reducing pollution by 6 units.

Answer 1

Firm	TC of eliminating two units of pollution
Firm X	55+70=125
Firm Y	650+800=1450
Firm Z	90+125=215

At 367 & 384 Firm X & Z will sell permit

Firm	Initial poll permits	Action	Final amount	Cost
Firm X	2	Sell one permits	3	55+70+110=235
Firm Y	2	Buy one permits	1	650
Firm Z	2	Don’t Buy/Sell	2	90+125=215

Proposed method	TC
Regulation	125+215+1450=1790
Tradeable permits	235+650+215=1100

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